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Bristol-Myers Squibb Co.

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Msg  7518 of 8462  at  7/25/2021 7:22:50 PM  by

teflon2000


Bristol-Myers Squibb Company: A Good Combination Of Value And Growth

Bristol-Myers Squibb Company: A Good Combination Of Value And Growth

Jul. 25, 2021 9:56 AM ETBristol-Myers Squibb Company (BMY)

Summary

  • At its current price levels, investment in Bristol-Myers Squibb Company represents a good valuate opportunity.
  • The opportunity features a good combination of value and growth, and offers double digit return potential in the next a few years.
  • In the long term, the business shows all the hallmarks of a compounder: strong existing product line, healthy pipeline, high return on capital employed.
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Thesis and background

The healthcare sector is a great place for value investors, ranging from legends like Warren Buffett to ordinary investors like myself for many good reasons. It caters to a fundamental human need that is not going to change or go away anytime soon. All signs show that the need will only intensified with population growth, longer life expectancy, more interconnected world, et al. The major players like Bristol-Myers Squibb Company (NYSE:BMY), due to their established lead and scale, are especially well poised to capitalize on such secular trend.

At its current price levels, investment in Bristol-Myers Squibb Company represents a good valuate opportunity. The opportunity features a good combination of value and growth, and offers double digit return potential in the next a few years. In the long term, the business shows all the hallmarks of a compounder – strong existing product line, healthy pipeline, high return on capital employed.

Before going into any further details, it would help to briefly summarize my investment philosophy to provide a context. I am a long-term, conservative, and value- oriented investor. I hold a rather concentrated portfolio with about a dozen stocks, diversified across different market sectors and supplemented by ETFs, bonds, and gold (as detailed here).

My goal for my stock holdings is to generate Double Digit return during a Decade, and that is why I nickname my portfolio the DDD portfolio. Currently my portfolio holds the following 10 stocks shown in the next chart. Using the date I first published the DDD portfolio on 5/31/2021 as the inception date, its performance on a weekly basis is summarized in the second chart. It has been a really short time compared to my horizon and there is no need to read too much into the specific numbers. At their current level (plus and minus a few %), they can all change within a day of random market fluctuation. And my goal is not to "beat" the S&P 500. It is to achieve DDD with good safety and good sleep at night. As reflected in my holdings, they all tend to be stocks with reasonable valuation, reasonable growth, high financial strength, and high quality.

DDD Portfolio stocks

Source: author.

DDD Portfolio returns

Source: author.

Overall impression of the healthcare sector and BMY

I’ve written about a few healthcare stocks in the past, including MRK, JNJ, GILD, and PFE. Based on these analyses, my overall impression is that the overall healthcare sector is currently quite reasonably valued, as can be seen from the following chart. Also, the market is ration in the sense that the valuation positively correlates with quality (as represented by ROCE to be detailed later). The appearance that BMY is off the trendline does not concern me too much. it is mostly due to the accounting uncertainties caused by BMY’s recent acquisition of Celgene, and the ongoing integration of this large acquisition. This significant acquisition created some temporary uncertainties and increased its leverage.

With the above overall discussion, we now move on to the specifics of BMY.

BMY vs. Peers

Source: author based on Seeking Alpha data.

The businesses and the moat

BMY Is a global leader in biopharmaceutical products. It is engaged in the research, development, manufacturing, and marketing of biopharmaceutical products worldwide. For pharmaceutical companies at this scale, it is all about A) bringing blockbuster drugs (with market value exceeding $1B per year) to market, and B) having a healthy pipeline of potential blockbusters. And BMY is doing a terrific job on both fronts as you can see from the following two charts. The first chart shows the performance in key existing products. As seen, BMY features multiple blockbuster drugs, and the Q1 2021 total sales was $11.1B, up 3% YOY. More specifically, for the top three drugs: Eliquis brought in $2.9B sales, and it is up 9% year over year; Revlimid $2.9B and up 1% year over year; and Opdivo brought in $1.7B and is down 3% year over year.

As seen in the second chart, BMY also maintains a healthy pipeline to prepare for the future. This large pipeline consists of large number of drugs. The lifecycle for a drug development (from the lab to the market) could take more than a decade. And therefore, the drugs in the later stage of the development, i.e., Phase 3 or later, are more important. And as can be seen, BMY has a total of 6 of them currently, encompassing key areas of oncology, cardiovascular, and immunology. Not all of them will be a blockbuster. And here is how the scale of BMY matters. Thanks to its scale, it does not need all of them to be blockbusters. It can afford the inevitable misses.

BMY Performance in key products

Source: BMY 2021 Q1 Earning Presentation.

BMY Clinical Development

Source: BMY 2021 Q1 Earning Presentation.

Profitability and financial strength

Thanks to its technological lead and scale, BMY enjoys superior profitability and financial strengths both relative to other peers in the same sector and also to the overall market, as illustrated by the following chart. The profitability is simply superb on every metric – both in absolute terms and in relative terms when compared to its peers.

The business is also in a very strong financial position, as exemplified by the next chart. Before 2019, it used to be essentially debt free thanks to its strong cash generation capability. Then due to its recent acquisition of Celgene, it increased its leverage significantly. However, there is nothing too concerning at all. The interest coverage (EBIT divided by interest expense) is still more than 7x. In other words, it only takes less than 14% of its operation income to cover its interest expenses. In contrast, the interest coverage for the overall market represented by SP500 is about 6x. Also as shown by the orange line in the chart, thanks to its strong profitability (and terrific return on capital to be detailed later), the business can also afford to pay off pretty much all the operation income as dividend after covering maintenance CAPEx.

BMY Profitability

Source: Seeking Alpha.

Source: author based on data from Seeking Alpha.

The valuation

As can be seen from the following numbers in the table, at its current price levels, BMY is undervalued by up to 40% by different valuation metric you use based on its historical valuations. In terms of absolute valuation, its current valuations (PE around 21x based on the GAAP and price/cash flow ratio around 11x) is on the lower end for a wide moat business leader. Note that I would not rely on the dividend of GAAP PE metrics too much here again due to the accounting uncertainties caused by BMY’s recent acquisition of Celgene. Admittedly, these uncertainties could be a risk as well if thing materials in the other direction. But I think the positive side is more likely.

BMY valuation

Source: author and Seeking Alpha

Based on the above analysis of the business fundamental, growth potential, and valuation metrics, it is relatively straightforward to project the return in the next a few years. Here let's consider the following "normal" scenario. This scenario considers the following return drivers:

1. 4% growth in total profit.

2. 1% share repurchases after the merger is fully integrated.

3. Dividend on the current 2.9% level (assuming dividend increase would keep the dividend yield approximately at the current level).

4. A valuation fluctuation around the mean due to market mood swing. If this occurs, it will cause about 5% CAGR in the next 3~5 years.

Based on the above return drivers, the annual return should be around 13% a year as shown below, with a total return of about 40% in the next 3~5 years.

Source: author

Long term return and perpetual growth rate

If you, like this author, are a long term investor who subscribes to the concepts of owner’s earning, perpetual growth rate, and equity bond, then the long-term return is simpler. It is “simply” the summation of the owner’s earning yield (“OEY”) and the perpetual growth rate (“PGR”), i.e.,

Longer Term ROI = OEY + PGR

Because in the long term, all fluctuations in valuation are averaged out (all luck at the end even out). And it doesn’t really matter how the business uses the earning (pay out as dividend, retained in the bank account, or repurchase stocks). As long as used sensibly (as BMY has done in the past), it will be reflected as a return to the business owner.

OEY is the owner’s earning divided by the entry price. All the complications are in the estimation of the owner’s earning - the real economic earning of the business, not the nominal accounting earning. Here as a crude and conservative estimate, I will just use the free cash flow (“FCF”) as the owner’s earning. It is conservative in the sense that rigorously speaking, the owner’s earning should be free cash flow plus the portion of CAPEx that is used to fuel the growth (i.e., the growth CAPEx). At its current price levels, the OEY is ~8.6% for BMY (~11.5x price to FCF).

The next and more important item is the PGR. To understand and estimate it, we will need to first estimate the return on capital employed (“ROCE”). Note that ROCE is different from the return on equity (and more fundamental and important in my view). ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how much additional capital a business needs to invest in order to earn a given extra amount of income – a key to estimate the PGR. For businesses like BMY, I consider the following items capital actually employed:

1. Working capital, including payables, receivables, inventory. These are the capitals required for the daily operation of their businesses.

2. Gross Property, Plant, and Equipment. These are the capitals required to actually conduct business and manufacture their products.

3. There are the following two possible routes here:

3.1. The first route is to include research and development expenses as a capital investment. As mentioned above, the R&D is the lifeblood for a sustainable pharmaceutical business and is not really an optional expense.

3.2. The second route is to amortize its intangible book value, mainly consisting of intellectual property and patents. This essentially treats the intellectual properties as capital with a finite lifetime, which I will assume to be five years, the average number of years away from its current blockbuster drugs’ patent expiration.

Based on the above considerations, the ROCE of BMY over the past decade are shown below. As seen, both approaches provided similar results, a good sign of the assumptions. BMY was able to maintain a remarkably high and stable ROCE over the long term: on average 43% for the past decade. To put things in perspective, as detailed in my previous articles for JNJ, the company with the highest ROCE in the group of healthcare stocks that I’ve analyzed, JNJ features a ROCE around 50%, not that far from BMY. Also to put things into an even broader perspective, as detailed in my previous articles for Lockheed Martin (NYSE:LMT) and General Dynamics (NYSE:GD), ROCEs for these defense business leaders, who almost enjoy a monopoly moat, are “only” in the range of 20% to 30%.

Source: author and Seeking Alpha.

With a 43% ROCE, it means that even if BMY only reinvests 1/10 of its earning to expand the capital employed, it could maintain a 4.3% PGR (PGR = ROCE * fraction of earning reinvested = 10% * 43% = 4.3%). And 10% reinvestment rate is indeed the situation here for BMY based on my analyses. As aforementioned, this is a reason that BMY can afford to pay off pretty much all the remaining income as dividend after covering its debt and maintenance CAPEx as dividend (or share repurchase). Of course, another reason is that businesses at this scale simply are not able to find that many opportunities to reinvest their earnings. But after all, 4.3% PGR already makes it a long term compounder with 10% income reinvested!

Now we have both pieces of the puzzle in place to estimate the long term return. At its current price levels, the OEY is estimated to be ~8.6% for BMY, and the PGR is about 4.3%. So the total return in the long term at current valuation would be a double digit around 13% as shown the chart below. Also as seen, even when ROCE fluctuates somewhat, the fluctuations wouldn’t change the long-term return dramatically.

Source: author and Seeking Alpha.

Conclusion and final thoughts

At its current price levels, investment in Bristol-Myers Squibb Company represents a good valuate opportunity, featuring a good combination of value and growth. Overall, the opportunity offers double digit return potential both in the next a few years. In the long term, the business shows all the hallmarks of a compounder – strong existing product line, healthy pipeline, high return on capital employed.

For me, I am not buying BMY only because my portfolio already holds enough healthcare stocks, which have similar return/risk profiles as I see. I just cannot have all of them and have to choose. My overall impression is that the valuation of the overall healthcare sector is in the range between fair valuation and undervaluation. High quality business like BMY, MRK, JNJ, PFE are all reasonably valued or discounted both in absolute terms and relative terms. With the long term secular support expected for the health sector, and the leading player high ROCE, I feel now is a good time to pick some quality stocks from this sector, either as a long term holding or to better diversify your portfolio.


 


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